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Check Volatility at the Door

Sector funds can be a lot more risky than they at first appear.

People tend to think of mutual funds as fairly buttoned-down investments, and in a relative sense, that's not an inaccurate assessment. After all, when you put your money down on, say, Taser International(NASDAQ:TASR), your returns might be stunning, but your investment rises and falls with the fortunes of that one particular company. If earnings disappoint or -- God forbid -- some kind of Enron-style accounting scandal erupts, you'll likely see the value of your investment plummet, at least in the near-term.

Even worse, the stock prices of perfectly sound businesses sometimes hit the skids simply because Mr. Market has one of his periodic mood swings. When that happens, erstwhile hot properties can become hot potatoes in a hurry. Remember when investors bailed on tech? Think about what happened to rock-solid titans Microsoft(NASDAQ:MSFT), Dell(NASDAQ:DELL), and Intel(NASDAQ:INTC) circa 2000, and you'll get the not-so-pretty picture.

Safety in numbersAt least when compared with individual stocks, investing in mutual funds is a pretty staid affair. Indeed, any fund worth your money should come outfitted with a well-diversified portfolio of holdings that provide broad exposure to the market's sectors and industries. That way, if one particular company blows up or a red-hot sector suddenly turns ice cold, the rest of the fund's portfolio is there to provide a cushion. A comforting thought, no?

Aside from convenience, the safety net offered by that kind of diversification is a main reason mutual funds have become the retirement-savings vehicle of choice for more than 90 million Americans. And not surprisingly, the ability of a manager to keep risk in check is among the attributes I look for when selecting any fund for my Motley Fool Champion Funds (which you can try for free by clicking here).

Foremost, I want to see a highly experienced manager at the helm, a talented stock (or bond) picker with a sensible investment strategy who has weathered numerous market cycles. I'm a big fan of strict sell disciplines, and if a fund weighs in with off-the-chart risk metrics (such as a high standard deviation of returns, which gauges a fund's performance range relative to its mean), it's unlikely to make the grade.

Simply put, investing in funds should be more akin to gliding over the hills and valleys of your favorite golf course en route to the 19th hole than a white-knuckled roller-coaster ride after you've gotten jacked up on a can or two of Red Bull. And, anyway, if you own stocks as well as mutual funds, like I do, I'll bet you a Red Bull that you have all the thrills and spills you can handle.

Risky businessMy orientation toward funds can help mitigate risk even when it comes to cherry-picking champs from among the industry's relatively racy aggressive-growth entrants. But make no mistake: Like any investment, mutual funds aren't risk-free. Their net asset values (NAVs) can decline, sometimes precipitously, and while assembling a solid portfolio of well-chosen mutual funds can be a terrific way to build wealth slowly over time, there's certainly no guarantee that your fund investments will always be on the upswing.

That said, there are at least two kinds of funds that will almost certainly never pass my risk-management test: sector funds and those that use leverage to juice returns. For the vast majority of fund investors, these puppies are just way more trouble than they're worth, in large part because they more or less undermine many of the built-in advantages that come with investing in mutual funds. I'll save a close look at leveraged funds for a future column, but read on for the gory details of my aversion to sector funds.

No more betsAs you'd guess, sector funds concentrate on just one area of the market, and they come in many flavors. Got a hankering for tech? How 'bout health care? Telecommunications, anyone? If so, there are plenty of funds out there vying for your investment dollars. Some even have strong long-term records. Take Fidelity Select TechnologyPortfolio(FUND:FSPTX), which, as sector funds go, is actually one of the better ones. The fund has been around since 1981, and for the 10-year period ended March 2003, it notched an annualized gain of 13.8% -- a mark that surpasses the S&P 500's over that stretch by more than two percentage points.

That's not too shabby. But just look at what investors have had to endure en route to those fat gains: losses of 32.3% in 2000, 31.7% in 2001, and 37.8% in 2002. Obviously, 2000 to 2002 was an especially tough patch for technology, yet even with 2003's impressive rally factored in, the fund still comes up a loser for the period. And a volatile one at that. Over the last three years, Select Technology has clocked in with a standard deviation of 41.8; the standard deviation for Vanguard 500 Index(FUND:VFINX) -- a world-class S&P tracker -- was just 17.3.

To be sure, relative to plain-vanilla picks, sector funds have loads of sex appeal. And some, like Select Technology, even have fine long-term records. Nonetheless, I can't recommend them. As a group, they're inherently volatile and tend to be pricier than diversified funds, too. I'd go so far as to suggest that, even for folks who think of themselves as investing daredevils (you know who you are), a sector fund should at most occupy a tiny sliver of a well-diversified portfolio.

After all, an all-star fund manager with a more liberal charter would at least have had the option of diversifying all that technology exposure with a Pulte Homes(NYSE:PHM), a Starbucks(NASDAQ:SBUX), a Harley-Davidson(NYSE:HDI), or even all three. Given the choice, I'll take the smooth ride every time.